Investing in Real Estate

Considering investing in real estate? Compound helps entrepreneurs, professionals, families, and retirees work through asset allocation decisions exactly like this one. None of this article is financial advice, but if you are looking for modeling tools or human advisors, we can help. Get started here.

Real estate is an essential service and attractive asset class for investors. It offers relatively resilient and tax-efficient cash flows that combine current income with long-term capital appreciation. Investors can choose their preferred real estate risk profile among a variety of options. It can be a particularly compelling diversifier for investors with high exposure to the technology sector.

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Real estate can offer attractive returns, protection against inflation, tax-efficient current income (depreciation can defer tax on current income), and resilience during an economic downturn. We believe both real estate investment trusts (REITs) and private funds can be compelling for long-term wealth creation.

Attractive historical returns

Real estate combines current cash flows with capital appreciation and has a long history of attractive returns. Publicly-traded REITs, represented by the MSCI US REIT Index, have a total return of 9.98% since inception in 1994 (compared to 10.37% for MSCI’s US investable stock market).

An index of core real estate strategies calculated by the National Council of Real Estate Investment Fiduciaries, the NCREIF ODCE, has returned 7.69% annually since inception in 1978 and 9.43% over the past 10 years.

Green Street Commercial Property Price Index (indexed to 100 in August 2007):

Key return drivers in real estate

Real estate returns consist of multiple components (helpful illustration on NCREIF slide 7):

• Cash flow generated
• Growth in cash flows
• Change in valuation (known as the “capitalization rate” or “cap rate”)

Properties are acquired at a cap rate of the current net operating income (NOI) divided by its market value. If one inverts this ratio (market value divided by NOI) it is a multiple of cash flow, analogous to multiples used to value a company.

Cap rates have declined significantly since the 1990s together with interest rates (see slide 21). This means that initial cash yields for newly acquired properties can be quite low and that growth in NOI has become a more important driver of returns. It also means that returns are more sensitive to changes in interest rates - rising rates could lead to higher cap rates and therefore lower returns when the properties are sold.

Real estate’s relatively stable cash flows enable the use of significant amounts of debt. The amount and cost of leverage can significantly impact returns. Properties that are held long-term and see significant growth in NOI can be refinanced at a higher valuation, allowing the owner to free up cash without having to sell the asset. 

Finally, real estate has several attractive characteristics that improve after-tax returns. Depreciation can be used to shield the property’s income. Upon the sale of a property, there exists the opportunity for a tax-free exchange which defers capital gains (Rule 1031).

The many flavors of real estate

There are many ways to invest in real estate. Investors can choose among different property types, quality, location, and riskiness.

Types of real estate:

• Residential: typically refers to single-family homes.
• Commercial: includes anything related to business (offices, industrial buildings, retail stores, etc.).
• Multi-family: apartment buildings.
• Office: includes everything from urban office towers to suburban low-rise office parks.
• Retail: shopping centers, malls, strip malls, but also fast food locations.
• Hospitality: hotels, casinos.
• Industrial: manufacturing plants, warehouses.
• Digital: (data centers, cell phone towers).
• Land: without buildings or improvements.

Real estate can be categorized by its riskiness and state of development:

• Core or stabilized: stable assets with predictable long-term cash flows but without much potential for immediate improvement. The lowest risk from an operational perspective.
• Value-Added: less predictable cash flows due to location, age, quality, or vacancies. Offers the potential for increasing cash flows through better management, redevelopment, or repositioning.
• Opportunistic: distressed situations, non-performing real estate loans, and other situations requiring heavy involvement.
• Development: properties at various stages from planning and securing entitlements to construction.

The cash flow profile and return drivers differ significantly between categories. Core investments offer stable cash flow and limited capital appreciation from growth. Value-add and opportunistic investments can offer significant growth and increase in valuation due to operational improvements. Development requires significant upfront investments until construction is completed and the property leased or sold.

Lastly, buildings are ranked according to their risk profile in categories called Class A, B, and C. These are relative rankings in the local market. This means a Class A office building in London can differ significantly from a Class A office building in Albuquerque in terms of prestige, rent, and amenities. These are determined by a mix of building age, quality of location, rents, perception and prestige, quality of amenities and finishes.

Class A buildings command the highest rents and are perceived as least risky. They can be landmark buildings or new construction and are often situated in prime locations. They offer the best amenities and attract tenants willing to spend on being in prestigious, beautiful, or extravagant buildings.

Class B buildings are one step down, a kind of middle market. These are typically older, more functional, and more affordable. They don’t compete at the same price as Class A buildings but offer a wide range of tenants a good home.

Class C buildings compete on price, offering a basic space at rents below average in their area. These buildings tend to be old and in challenging locations. They are considered riskiest by investors but can offer high cash-on-cash yields.

What type of ownership?

Inventors can gain exposure to real estate through both equity and debt. We believe equity is more compelling for investors with a long-term time horizon and focus on capital appreciation. Equity exposure can be gained either directly (by buying a property yourself) or through ownership in a pooled vehicle like a corporation, for example a public or private REIT, or a partnership (such as a private equity fund).

Purchasing and renting property directly offers the most control and has a long history among high net worth investors. However, it is not suitable for every investor. Direct ownership:

• Requires time and effort to source and purchase a property as well as manage it (or hire a manager).
• Can lead to significant concentration in the portfolio if the property is expensive.
• Can lead to a version of home country bias as investors are more likely to purchase properties in the local market they’re familiar with.
• Can be difficult to liquidate if the investor needs funds (depending on the market and type of property).

An alternative is to invest in a diversified portfolio through a public or private REIT or fund structures (or a real estate ETF or mutual fund).

REITs receive a special tax treatment in that their income is not taxed at the corporate level as long as they meet certain qualifications outlined in the US Internal Revenue Code. Most importantly, at least 75% of its assets must be invested in real estate (or cash and cash equivalents), at least 75% of its gross income must be from real estate-related activities such as rents, mortgage interest, or real property sales, and 90% of its taxable income must be paid out to shareholders each year.

REITs are a common and popular choice for investors. However, they are evergreen investment vehicles and not intended to liquidate. By comparison, a private limited partnership has a set life to acquire, manage, and liquidate a portfolio of properties, analogous to a venture fund.

Because REITs distribute their income, they need to raise external capital to grow their asset base. This makes them dependent on market valuation and they can trade at premiums or discounts to their fair value. For investors this means that public REITs can offer liquidity but also volatility and possibly an unattractive price to exit.

“Location, location, location.”

Real estate is a local affair. Returns can vary significantly across local markets and types of properties driven by demand and supply. If new supply is constrained, such as by zoning laws or geographics limitations, existing real estate can appreciate rapidly (think San Francisco or New York). If however the city can sprawl out, appreciation is often more limited.

Demand in the form of local population growth and business activity is a second key factor. If a city’s population declines significantly, its real estate market can become extremely challenging (think Detroit). While real estate has limited risk of disruption, occasionally this does occur such as for malls (ecommerce) and increasingly office as companies opted for work from home.

At Compound we believe that multi-family real estate can be the most attractive diversifier for an investor with no prior exposure to real estate. After the financial crisis, housing construction in many secondary markets of the U.S. lagged demand. Restrictive local zoning further constrains supply. As a result, rent growth and occupancy in many secondary markets can be expected to be resilient for some time.

What are the risks?

Real estate cycles are typically a regional phenomenon. The great financial crisis and the great depression with their nationwide downturns were the exception. High-growth markets or economies tied to a cyclical sector tend to undergo boom-bust cycles (such as Texas, California, Florida, and other sunbelt states). Other markets, for example Detroit, can see decades-long downturns if the local economy deteriorates and population declines.

• A down cycle in the economy could lead to a broad-based decline in property values. Recessions impact occupancy, rents, and therefore NOI.
• The amount of leverage used can exacerbate any property-level issues.
• Rising rates can lead to declining valuations (meaning an increase in the cap rate) and a higher cost of debt. After several decades of declining rates, this would be a more challenging macro environment and a headwind for returns.
• Investors in value-add, opportunistic, and development assets always face operational risks. Their efforts to turn around low or negative cash flowing properties may fail. Developments can see delays, cost overruns or low uptake after completion.
• Overbuilding can lead to local downturns.
• Some sectors struggle with disruption such as retail (ecommerce) and office (work from home).

What to look for in a real estate investment manager

• Track record: what is the manager’s track record of improving properties, growing NOI, and managing properties through a downturn?
• Local footprint for origination and execution: does the manager have a local presence in their active markets or do they rely on the knowledge and network of brokers?
• Integration and breadth of capabilities: does the manager have in-house capabilities to source and execute as well as manage properties or do they rely on outside service providers? How many markets and sectors do they cover? Large managers may be able to opportunistically take advantage of dislocations in public markets or pivot between sectors without having to get up to speed. Select smaller managers may have strong networks and expertise and see better deal flow in their niche.
• Capital discipline: how disciplined is the manager’s capital deployment and underwriting? What valuations are they paying? Are they able to achieve their underwriting assumptions?
• Fee structure: it is important to understand and compare how many layers of fees a manager charges in addition to the management fee and carry.

Conclusion

Real estate offers multiple reasons to invest, most notably a hybrid of current income and long-term capital appreciation. It can protect against inflation and act as a diversifier in equity and fixed income portfolios. However, much depends on selecting the right market, asset type, and investing at an appropriate valuation. Rising interest rates can present a new headwind. While direct ownership can be attractive for hands-on investors with sufficient capital, we believe select REITs and private funds can be compelling investments.

Considering investing in real estate? Compound helps entrepreneurs, professionals, families, and retirees work through asset allocation decisions exactly like this one. None of this article is financial advice, but if you are looking for modeling tools or human advisors, we can help. Get started here.